Testimony of James P. Esposito to the Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of Representatives
James P. Esposito provides the firm's perspective on the municipal bond markets
Testimony of James P. Esposito, Managing Director, Goldman, Sachs & Co. to the Subcommittee on Select Revenue Measures, Committee on Ways and Means, U.S. House of Representatives
Chairman Neal, Ranking Member Tiberi, and Members of the Committee, my name is Jim Esposito and I lead the Municipal and Corporate Investment Grade new issue financing business at Goldman, Sachs & Co.
I appreciate the opportunity to appear before you today to provide Goldman Sachs’ perspective on the municipal bond market, particularly new programs providing innovative taxable bond options to both issuers and investors. Given my leadership role across both the taxable and tax-exempt capital markets business, I have a broad perspective on the new programs enacted by Congress as part of the American Recovery and Reinvestment Act (ARRA) and signed into law by President Obama on February 17, 2009.
Mr. Chairman, as your invitation to testify requested, my testimony will focus on the reaction by both issuers and investors to two particular programs: the Build America Bonds (BAB) and the Qualified School Construction Bonds (QSCB). These programs have had a materially positive impact in the following areas: 1) lowering borrowing costs for state and local governments, 2) providing issuers a needed source of capital to fund infrastructure projects, and 3) improving the functionality of the capital markets for issuers and investors.
Goldman Sachs and Municipal Finance
Goldman Sachs has a long history of helping states and municipalities access the capital markets. Since Goldman Sachs entered the public finance business in 1951, we have been one of the largest industry participants. We serve our municipal clients in many capacities, including acting as advisor, market-maker, underwriter and co-investor to help them meet both their short and long-term financing goals. Over the past 10 years alone, we have helped states and municipalities raise over $250 billion of total capital.
Our business at Goldman Sachs is institutionally dominated, with the vast majority of our capital commitments made on behalf of corporations, institutional investors and governments. We do not engage in many traditional commercial banking activities and are not a significant lender to consumers. As a financial institution focused primarily on this “wholesale” client base, Goldman Sachs provides liquidity to institutions, which is a vital component of a functioning capital market.
Goldman Sachs is an active member of the Securities Industries Financial Markets Association (SIFMA) and serves as the chair of the SIFMA Municipal Securities Division. SIFMA’s Municipal Securities Division has been vigorously supportive of proposals, like the taxable bond options that are the focus of this hearing and provide capital access and liquidity to municipal issuers.
The Municipal Market Before BABS
Historically, the $2.5 trillion municipal debt market had provided states and municipalities access to capital at affordable borrowing rates. The credit market deterioration of 2008 created an exceptionally challenging environment where only the highest-rated municipalities and corporations had access to the market. Certain institutional investors exited the market permanently and others sat on the sideline to wait out the storm. During this time, the auction rate market failed, the variable rate market experienced significantly higher interest rates and an overall lack of liquidity pervaded the market. It became clear that expanding the traditional buyer base for municipal securities was needed to restore stability and long-term viability to the municipal market. Although the beginning of 2009 saw an improvement in some of these areas, a broad portion of the market was still unable to issue debt. Throughout this period, tax exempt bonds traded at historically high yields relative to Treasuries. Under normal market conditions, yields on highly rated municipal bonds trade with a yield between 80-90 percent of respective Treasury yields. During the peak of the credit crisis, municipal yields moved as high as 209 percent - a clear sign of dislocation in the market.
Attached to my testimony is a chart that illustrates this point.
Markets Are Validating BAB Taxable Bonds
The taxable Build America Bonds (BABs) provide eligible municipal issuers the ability to issue taxable bonds and receive a 35 percent direct payment from Treasury to pay a portion of the interest on the bonds. BABs are proving to be a major success with issuers and investors alike with $9.25 billion in issuance from 27 different municipal issuers since the ARRA was signed into law on February 17th. Major issuers from across the country have issued BABs in the last month, including the University of Virginia, the State of California, the New Jersey Turnpike Authority, the Metropolitan Transportation Authority of New York, the Illinois State Toll Highway Authority and even smaller issuers such as Sedgewick Kansas Unified School District, the City of Glendale, Wisconsin and the City of Council Bluffs, Iowa.
The passage of ARRA and enactment of the BABs program gave municipal issuers access to a new, robust buyer base in the taxable investment grade market. Investors that previously did not buy municipal debt because they could not take advantage of the tax exempt status, now could achieve comparable after tax returns. To give you a sense of the comparative scale, the taxable market currently has over $6 trillion in outstanding debt as compared to the $2.5 trillion tax-free municipal market. Access to this new taxable investor base has helped municipal issuers diversify their funding sources by tapping a new and deep pool of liquidity. Two key observations about recent BABs financings:
Supply Demand Balance Restored- BABs issuance has taken some of the supply pressure off of the traditional tax-exempt market. This has improved the supply and demand balance resulting in lower borrowing costs for municipal issuers as the benchmark for pricing tax-exempt bonds has reduced notably since ARRA was passed. Build America Bonds have not eliminated the need for a tax exempt market, but rather have provided an alternative through 2010. The traditional tax-exempt market will continue to be attractive for certain issuers. A positive effect to the $9.25 billion of BABs issued to date is the visible resurgence of the traditional tax-exempt market.
Structuring Flexibility and Price Discovery- The BABs alternative provides a compelling financing tool for states and municipalities to meet their borrowing needs. Creating the opportunity to access a separate and distinct buyer base, issuers can now select the lowest all-in cost of funding, comparing investor demand, and price views up until the bond pricing date. As taxable investors grow more comfortable analyzing municipal credits, we are seeing an increased amount of structuring flexibility and price tension. Recently, taxable investors have been willing to purchase callable and amortizing bond. Further, BABs pricing has become even more attractive for issuers, directly lowering the borrowing costs for states and municipalities.
Qualified School Construction Bonds
The other taxable program created by ARRA is the Qualified School Construction Bonds (QSCBs). Two factors will drive the ultimate success of QSCBs:
Size of the Program- With $22 billion of tax-credit financing authorized and allocated to states and large school districts to fund their capital needs for K-12 education through 2010, the program has attracted immediate attention of issuers and prospective investors alike. We believe a robust market will develop including a broad investor base. Goldman Sachs was privileged to complete the first QSCB transaction last month with the San Diego Unified School District. Although the issue was small in size, $38.8 million, we were able to identify and educate a buyer base that did not previously exist. We believe this initial QSCB offering will be the first of many as states and investors gain full understanding of this valuable tool to finance education.
Interest-Free Financing- With states and large school districts able to fund education capital needs on an interest-free basis, this program provides a valuable financing option.
The QSCBs and other tax-credit programs created and expanded under ARRA contain more attractive investment provisions for both issuers and investors than previous programs. However, with only one publicly traded issue sold to date, the ultimate benefits of this tool will only be transparent as markets evolve.
Further Aid to Municipal Issuers
While BABs have succeeded in easing the strains for longer maturities, there are still short-term funding problems. There is a general liquidity issue, and states and cities are at risk of not being able to pay day-to-day obligations as their tax bases shrink, credit facilities expire and access to new capital may be limited. Additional legislation may be needed to address these issues. For example, legislation recently introduced by House Financial Services Committee Chairman Barney Frank aimed at providing short-term liquidity to municipal issuers could help address a number of key concerns.
The municipal taxable bond options enacted in ARRA have had the immediate effect of lowering borrowing costs to state and local governments while providing investors with a new opportunity to diversify their portfolio holdings. Congress and this Committee specifically should be commended for providing municipalities’ access to new liquidity sources during challenging times. We encourage Congress to monitor the stimulus-related financing programs to determine if, at the end of 2010, any or all of the programs warrant extension or expansion. Goldman Sachs is committed to the municipal bond market. On behalf of Goldman Sachs, I appreciate the opportunity to appear before the Subcommittee today to share our views and look forward to any questions.